Chapter 3 Economics of Patents and Economic Rationale for Exhaustion in Relation to International Trade

In: Patent Exhaustion and International Trade Regulation
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Santanu Mukherjee
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3.1

3.1.1 The Economics of Patents

In the earlier chapters while discussing the rational for the patent system, the economic incentive for the inventor became most prominent among all reasons. It was also discussed by Edith Tilton Penrose where it was very clearly stated that patent protection is based on economic costs and gains. So, the loss from restricting the use of inventions and creating a monopoly situation can be balanced depending on factors like size of the national market, nature of national industry, motivation of inventor and the method of financing available to the inventor.64 However the nature of knowledge being a public good, irrespective of its use by any person at any given time would not restrain use by others, once placed in the market. Hence once made public, it is not possible to restrict use and enjoyment by others. In such scenario even when the inventor puts in labour and spends time and money, others can ride on the invention without bearing any of the costs or in other words, free ride on the inventor’s efforts. Thus, the intangible nature of the ip makes it easily vulnerable to copying and replication creating inherent externalities. These inherent externalities invariably lead to market failure and as a result, attract only low levels of inefficient innovation. The patent system helps avert such market failure by curving out property rights for the inventions of the inventors.65 These property rights on human creativity leading to invention are in line with traditional property rights and based on freedom of choice, as it should be in the case of any standard goods and services.66

Microeconomics models are based on perfect market competition wherein price is the sole criteria that determines competition. This is based on the concept that such markets are completely homogenous and there are number of suppliers in the market. Such market situation leads to perfect competition wherein there is social surplus consisting of consumer’s surplus and producer’s surplus. However, in the real market situation the scenario is different, there is hardly perfect competition. The products are not homogenous in nature and thus price does not solely influence the consumer’s market behaviour, quality also plays a vital role. Mandatory enabling disclosure to obtain patents enables opening up of primary research through such processes and encourages follow-up innovations while reducing wasteful innovation races.67 In such a situation patent enhances market performances by excluding products (resulting from innovative technologies and thus promising better quality) from market competition for a short period.

Early works of the noted economist Fritz Machlup in his report to the US Senate states that the most relevant economic reason for the patent system is the possibility of commercialisation of new products. Considering the economic case in favour of the patent system, the fundamental issue he says, is more commercial than the incentive to the inventor.68 He argues that the patent system provides the possibility of the inventors to obtain investments to enable production based on the invention and that is the fundamental economic reason for the patent system to sustain and succeed. Interesting to note that he discounts the importance of enabling disclosure as a social good and argues that it is the possibility to protect the invention from unauthorised use that is most crucial.69

The fact that one of the economic reasons for the patent system is to provide legal protection from copies, inventors would invariably try to protect their inventions and in absence of patents would opt for some other means. D. D. Friedman, W. M. Landes and R. A. Posner argues that in absence of patents there would be a tendency of protecting the inventions through trade secrets. This would take away transparency and the possibility of enabling disclosure and foreclose possibilities of enhanced research and innovation based on published patent data.70 Even if we accept Machlup’s position for argument’s sake, that the enabling disclosure is nothing but an illusion, the fact that throughout ages many patents have built on published patent data and by means of patent landscaping, disclosure remains crucial to the patent system.

To correct market failures, countries use their iprs in a manner that is best suited to their industries and markets. Here it must be noted that laws on iprs including patent law is territorial in nature, thus there are often differences in the patent law of one country from another. For this reason, trade between countries having different parameters in their patent rights could face market distortion. For example, if a country’s patent protection is weak while in another it is stricter, competitors of the patent holder in a country with weaker protection would be able to gain undue benefit. They would prefer to piggyback on the investments made by the patent holder without any substantial investment and gain commercially when these products are traded internationally. iprs were brought within the purview of wto through the trips Agreement based on this reason. The trips Agreement introduced minimum standards of protection of iprs, harmonising the bottom floor of protection of ipr laws of members. Through this harmonisation the transaction costs incurred in operating in different regulatory jurisdictions is reduced (although not eliminated since trips does not bring 100% harmonisation of ip laws).71

Patents are granted to inventors as lead-time over competitors by way of market exclusivity for their contribution to scientific and technological development. It also helps to recover fixed costs incurred in research and development. It is found that when the fixed costs are high and it is easier to invent around the patent or copy the invention, greater patent protection is needed to provide sufficient incentives.72 As discussed earlier, the secondary reason for patents is based on the logic that if the inventor was not provided with legal protection, then free riding on the invention would lead to unfair gain at the expense of the inventor. The patent holder is thus provided sufficient market exclusivity that act as monetary incentive enabling supra-normal profit. The main economic reason is that when the elasticity of demand is low due to lack of competition, the patent holder would be able to charge more and cover its expenses as well as make monetary gains. Here it should not be ignored that countries might not have economic interest in defending inventions via patents if the monetary gains from such inventions accrue to inventors in other countries. For this reason, there will be a big tendency to make copies of the invention at marginal cost of follow up r&d investment.73

The main reason for providing patents is to balance the externalities in producing new technologies at one hand, and the ‘collective good’ character of these technologies on the other hand since the social value is often higher than the private value resulting in market failure even in perfect competition.74 In such circumstances the role of patent is to correct the market failure by creating incentives to invest and by increasing the private value of the new technology. However, there is also a counter argument that knowledge assets like new technology are products of the mind and are hence public goods that should not be privatised. Subsequently the argument follows that governments should intervene in production of such knowledge assets and maintain them as public goods, mainly by funding research in Universities or r&d related to defence. They can themselves create knowledge (which can be funded by taxes) and make it available free of cost to the public or provide subsidies to private individuals or bodies to produce such knowledge (the subsidies can be financed by taxes).75

Richard Nelson elaborates on this further and states that profit-seeking firms might not be able to capitalise on all the investment made in fundamental scientific research due to uncertainties resulting from imitators. Hence as these profit-seeking firms are basically risk-averse, they would be constrained to invest in fundamental research.76 True, profit-seeking firms might be averse to investing in fundamental research and such research would likely be conducted in Universities and r&d institutions. However even in such cases of public funded research, role of patents would still be crucial. There might not be an interest in private proprietorship of public-funded research per se, but when such research would need to move to the next stage, transforming the invention to a new product, patents would help in technology transfer through licensing or assignment of the technology. Typically, patents would help in market valuation of the research in a manner that the private party interested in the invention can use the patent to transition from laboratory to the market via licensing or assignment.77

It must not be ignored that since patents are related to knowledge assets, they enhance appropriability of knowledge and boost investment in r&d. For this reason, they are the solution to the ‘quasi-public good’ characteristic of knowledge assets. On the other hand, they can also cause market distortion since the market exclusivity can lead to an abusive monopoly, inappropriately increasing the patent holder’s market power. Thus, it is important to note that although patents are granted to increase the private value of the new technology, certain checks and balances are necessary to make sure that the private value does not supersede the social value. From the above analysis it can be stated that the basic requirements of enabling disclosure, inventive step and utility are the essentials to minimise the social costs. Similarly patent rights have restricted duration of 20 years from grant (filing) with the same intention of balancing private rights and public interests. This book presents that ‘exhaustion of patents’ further helps create a balance between the two in addition to the restriction on the patent rights imposed through a fixed duration of 20 years.

3.1.2 The Economic Arguments for Free Trade in Relation to Exhaustion of Patents

Arguments in favour of free trade are based on the Ricardian theory of comparative advantage, introduced by David Ricardo nearly 250 years back.78 According to this theory, in two national markets where two different commodities are traded, if one market has an absolute cost advantage over the other in one product and the other country has absolute cost disadvantage in the second product, one product is manufactured at a relatively higher price in each of the two countries. Hence if a country is more efficient in producing one product while not so in the other product, it can choose to produce only the one in which it is efficient and import the other product. There is a trade-off for the country to produce what is more efficient in that country and import what is not, instead of producing every product locally even when the country does not produce it efficiently. In economic terms, this trade-off is called ‘Opportunity Cost’.79 If the opportunity cost is lower in producing certain product than importing from other countries, then the country will have comparative advantage in producing it locally. The comparative advantage establishes that it is economically more advantageous for a country to produce the goods and services in which it is efficient and not produce those in which it is least efficient. Each country can then trade with the other countries on their efficient produce and both benefit from trade.

Thus, if both the markets relinquish autarky80 and adopt international trade then consumer welfare in both the countries will increase. It is known that consumers benefit as market competition brings down price, resulting in economic efficiency. This fundamental argument in favour of removing trade barriers is to generate economic surplus based on comparative advantages.

The Ricardian theory is based on the concept that international price differences are solely caused because of cost differences. However, in real life circumstances this is not necessarily the case, Ricardo did not consider number of factors, e.g. transportation that would affect pricing. Moreover, if there is no perfect competition due to external factors, or monopolies, or preferential differences towards the commodities that are traded between one country and another, there will be artificial price differentiation where this theory would not work. One might argue that firms adopt price differentiation to cater to different markets with different levels of wealth and income so that the products are available in both the markets. However, in Arthur Cecil Pigou’s seminal work on externalities, he describes that the sellers adopt price differentiation to maximize profits.81 So one might conclude that a market of people with low income and low wealth will not be catered to even by lowering the price if economies of scale cannot be achieved. In such situation international exhaustion to import the products from any other country market where it is available at a cheaper price could be a viable option.

It has been already discussed that patents are market exclusivities that can become restricted monopolies but have the sanction of law. In terms of the Ricardian theory this means that such exclusivities or monopolies will affect the price of the patented commodities. Thus, the international price difference between commodities manufactured in different countries will not solely depend on differences in costs, but also be influenced by these patents. In such circumstances where the patent holder is authorised to have market monopoly for a restricted time, he would benefit most if he assesses the price elasticity of demand for the patented product in different markets and prices the product differently. This would allow him to increase his profit not only from working the patent but also from the consumer’s surplus in each market.82

All this will lead to different prices for the patented products in different markets. Naturally, if these patented products are cheaper in one country than the other, some people will buy such products in the country where it is sold at a cheaper price and sell it at a higher price in the country where the price is high. This type of activity is defined in economic terms as ‘arbitrage’. Such arbitrage will balance the act of the patent monopoly from exceeding its mandate since it will restrict the monopolist’s gain from the consumer’s surplus although not restricting his benefits from the patent. Obviously, patent holders would not prefer to reduce their financial gains and might argue that, in general the patent allows him to exclude competition and thus s/he should be allowed to restrict competition from her/his licensees. It is debatable whether the exclusion from price competition should include those products that are brought to a different market by the patent holder himself.

3.2 The Economic Reasoning for Patent Exhaustion

The fundamental reason for adoption of exhaustion of patents is to place a checks and balances means to control possibilities of excessive market power gained due to ubiquitous nature of patents. Ubiquity allows patent rights over multiple number of units of a product situated at different places at the same time. Hence the patent holder can exercise control over the patented products in different markets even without having any physical control over the products, thus, bringing the much-needed legal security in trade and commerce.

Exhaustion of patents enable mitigation of the deadweight loss that occurs due to the exclusivity of the ip resulting in the ability to price above market competitors.83 As mentioned earlier, exhaustion of patent right allows minimising the social costs, thus balancing the private value and social value of an invention. The exhaustion principle as such is generally accepted without much debate, however the issue at the centre of all debates is not whether the patent right should exhaust, but on how and when such exhaustion should be.

Some economists tend to support price discrimination to the extent that different groups of consumers are ready to pay different prices at different length of the demand curve. Hence, where the demand curve is relatively inelastic the price can be high and where the demand is elastic price can be low. Arbitrage would result not only with the exhaustion of patent but also if the prices have been artificially manipulated due to government control, hence it is important to address it carefully to avoid any unintended market distortion.84

Here it is important to note that exhaustion would enable parallel trading of original patented products placed on a foreign market by the same right holder. Such product should not in any manner be confused with illegitimate products that have been manufactured without the permission of the right holder. Hence the essence of iprs to exercise enforcement restraints on such infringed products would remain unhindered in any manner since the right is not existing in the first place, cannot exhaust when the product is paced in the market. There needs to be a definite policy as to how such arbitrage is to be treated. Details of different economic reasoning are analysed below to elaborate the three types of exhaustion and highlight the ideal mode of exhaustion.

3.2.1 Economic Reasoning for ‘National Exhaustion’ of Patent Rights

National Exhaustion’ of iprs enables arbitrage but restricted within national boundaries of the market. Some economists support such exhaustion since they support the exclusive territories that this exhaustion establishes.85 This exhaustion restrains arbitrage to the national boundaries. This help in maintaining exclusive market territories that are argued to encourage investments in local services and beneficial price discrimination, thus enhancing economic welfare. They are more inclined to favour patent holders who argue that the restrictions on arbitrage are necessary to provide legitimate protection to patents. According to them, since national exhaustion allows the patent holder to maximise profit in each market, they allow overall increase of their profit and thus benefit the patent holders.86

In addition, it is stated that by following national exhaustion, the patent holder can control the movement of the goods by controlling the imports of the patented products.87 Thus according to this school of thought, arbitrage should be restricted to any economic free riding on the promotional and advertising expenses incurred by the authorised distributor based locally. In such cases it is argued that the parallel exporter free rides on the externality, which reduces efficiency especially in products tied with after-sales service. Further, if there is any material difference between the products sold in the parallel channel and the authorised channel there is obvious welfare reduction.88

It is also argued (although not from a purely economic perspective) that if unrestricted arbitrage is allowed, there may be consumer confusion wherein the consumers will be deceived as to the origin of the product. Here it must not be ignored that in case of re-imports, the same firm manufactures the products and only the markets in which they are sold are different. Thus, this argument can be made only in cases where the products are manufactured by the patent holder and the licensee separately and marketed in tandem. In any such case whether the country of origin is mentioned or not would not make any difference so far patent exhaustion is concerned. It would only be an issue in case of the exhaustion and can be dealt with appropriately. However, in such cases the patents would not exhaust if the producer is different, the exhaustion will only trigger when the patented product originates from the same company or its subsidiaries (holding company).

Considering this argument from the perspective of patents, such notion is based on the belief that confusion may occur since there is a high quality product, manufactured by the patent holder and a low quality product manufactured by the licensee of the patent holder.89 It is argued that if the manufacturer prefers price differentiation for different markets then there cannot be different products in the same market and thus there cannot be confusion between the two products in the same market. Here it is indeed important to note that if there is material difference between the locally originated goods and the parallel imports of inferior quality, they can be restricted from being marketed.

There is a well-established legal practice in Trademarks law in most countries that does not allow exhaustion if there are material differences in the goods.90 Similar restriction on exhaustion, i.e. same treatment as in the case of trademarks can be accorded to patented products that are materially and physically different. However, the burden of proving inferior quality would be on the complainant, hence the authorised distributor in the country or the licensor of the patent. This would be rather tricky, as it would acknowledge that the patent holder markets inferior quality products in some markets even when it has the capacity to market better quality. Restricting licensee’s products through restriction on parallel import is beyond economic reasoning. It can be argued that imposing restrictions on arbitrage to restrain intra-brand competition of patented products through restraints on parallel imports only curtails spread of innovation through technology transfer.

Critics argue that arbitrage decrease global economic welfare since it restricts price discrimination.91 It is argued that price discrimination where different price is charged for different price groups help in profit maximisation. However, such arguments are often based on the assumption that the patent holder’s product is different in quality than that of the licensee, which need not be the case. It is also noticed that if arbitrage is allowed, since both the patent holder’s product and the imported product would be on the market, in case of less demand in the low-income country, the patent holder will not be interested in supplying this market, hence the low-income market would only get the (supposedly) inferior products. On the other hand, if there is less demand in the high price market, the patent holder would try to monopolise the high-income market thus low-priced products manufactured by the licensee will not reach this market. In such a pareto-inferior situation neither the consumers in the low-income country, nor in the high-income country would be better off. The consumers in the low-income country would not get the better product while the consumers in the high-income country would not get the cheaper products, thus restricting access to the products in poorer countries. However, it needs to be reiterated that imports of inferior quality products can be restricted based on their material difference.

Some others argue that restraining arbitrage is welfare enhancing since this would allow the patent holder to cater to the markets of the high-income country as well as the low-income country by differentiating the prices of the same product. They state that when the transaction costs are low, low-priced buyers would try to resell the products at high-price markets and due to this the patent holder will try to opt for uniform pricing and this will be detrimental to consumer welfare in general.92 Thus according to them, consumers in both the countries would be better off if price differentiation is allowed. It is argued that there will be a tendency by the patent holder to decrease the price in the high-income country to enable competing with the parallel imports. Hence to recuperate the loss, there would be an increase in the price of the product in the low-income country from where it is being sourced. This would result in equalising the price of the patented product in different international markets, thus reducing the welfare in low-income countries. Others take a more liberal view and state that although one might argue in favour of restricting re-imports that are priced low and meant for low-income markets, there is no reason to restrict parallel imports in general.93

Price-differentiation is based on the relative elasticity of demand where in the relatively elastic market consumers will be charged lower price and in the relatively inelastic market consumers will be charged higher. Hence the economies of scale matters too, higher demand for the product also affects price. In such scenario, it is also argued that in cases where low-income countries benefit from lower price due to price competition, if the inflow of parallel import is from another low-income country, the exporting country might experience a price rise. This is because there would be a tendency to disallow arbitrage by the patent holder and not cater to a particular country market, however such conditions also need to consider remedies of cl available.94

One might also argue that restricting arbitrage and setting prices independently in each country to allow charging a mark-up price over marginal distribution costs based on ‘Ramsey pricing95 is beneficial.96 The sunk costs in r&d (which although benefits users in different markets) are borne locally and can be recovered efficiently if the mark up is fixed in different national markets according to the elasticity of demand in that market based on Ramsey pricing. Accordingly, prices will be set differently in each country in a manner that the mark-up of price over the original cost, rise with a fall in the elasticity of demand, so as to cover the sunk costs. Thus, market segmentation can help in financing new r&d but here it is important to note that this treatment should be specific to re-imports rather than generically applied to all imports based on national exhaustion of patents.

It needs to be highlighted that often the reasoning provided by the proponents of national exhaustion are based on theoretical simulation models on economic assumptions since sufficient empirical data is not available. In absence of specific data, Glanslandt and Maskus prepared an econometric model and deduced on instrumental-variables estimation.97 The aim was to determine effect of exhaustion but there are a lot of assumptions made, based on hypothetical situations that might not reflect the actual situations. In such scenario, given that these models can provide quite different results if there is even slight change in the variables, these models are not reliable.

3.2.2 Economic Reasoning for ‘International Exhaustion’ of Patent Rights

The basic economic reasoning for international exhaustion lies from the very nature of the exhaustion doctrine itself. International exhaustion enables restraint-free distribution of the patented products once financial compensation gained either through sale or royalty/license fees on distribution. Supporters of international exhaustion view that allowing arbitrage would restrict the possibility of patent exclusivity being extended to unrestrained monopoly that is susceptible to abuse. On the other hand, while it puts a check on the unrestrained use of patent exclusivity, given the fact that the patents are still enforceable against infringers, it does not compromise the welfare introduced by the patent. It is argued that allowing unrestrained arbitrage prevents the possibility of collusive tendency that might arise in the patent holder due to private territorial restraints. Moreover, international exhaustion enabled parallel imports counterbalances against abusive price-discrimination when government enforcement on territorial rights causes rent-seeking behaviour.98

One needs to consider that parallel trade can happen only when there is not just international price difference, but only if the difference is sufficient to cover the transportation costs leading in profitable arbitrage.99 Critics of international exhaustion argue that if international exhaustion is adopted, the patent holder would not price discriminate geographically hence the importer would not be able to import at a lower price. This would thus increase the price of the patented goods in the import market, negatively affecting the consumers.100 In other words, the patent holder might try to increase the price in the low-priced markets to bring in a uniform price thus killing the welfare enhancing possibility of international exhaustion if introduced without any control mechanism. This argument may hold ground only in cases where the patented goods are manufactured in States having similar economies like in the European Union (EU). If the markets are large while the consumers are not financially able to pay higher costs of the patented goods, the patent holder will adopt lower price for this market especially when the market is big and seek profit by scaling up sales.

They also argue that countries often achieve low prices only by price regulation and not through efficient production hence distort production efficiency.101 This argument completely ignores the fact that the lower price might be not be due to price regulation but because of lower cost of production in a country. One cannot undermine the fact that the patent holder (as a price-discriminator) would obviously try not to allow arbitrage so that it can make maximum profit.

Another argument is that arbitrage does not bring welfare effects for the consumers, it allegedly benefits only the intermediaries. But such arguments are not supported with sound empirical data.102 Although there has been some empirical research in the pharmaceutical sector, it has been restricted only within the European Economic Area (eea). As such, the parameters considered for the empirical research would not give the same results if extrapolated to other geographical areas. Even then, studies have shown that moving from a national exhaustion regime to regional exhaustion regime in Sweden had led to significant reduction of pharmaceutical prices which made it clear that the welfare is enjoyed by the consumers and not just the intermediaries. Conclusions of this sort often fail to consider the importance of the size of the market and issues like economies of scale and the bargaining power of the consumers. It is already recorded that, patented products are often more expensive in smaller developing country markets than in bigger developed country markets.103 International exhaustion, stimulates competition neutralising the effectiveness of price differentiation and enhancing free trade. Hence one cannot negate the fact that based on real life situation, many developing countries are opting for international exhaustion.104

It is further argued that the parallel importer free rides on the promotional and advertising expenses incurred by the authorised distributor. In today’s global reach of media, advertisements travel beyond borders even if they might be locally oriented. Hence even if the advertisement expenses are borne exclusively by the authorised distributor the benefit is enjoyed globally by the patent holder. Moreover, often the manufacturer itself also incurs promotional and advertisement expenses. This is internalised by all the distributors (authorised as well as the unauthorised) hence the argument of free riding does not hold ground.

It is important to note that the patent holder’s products as well as the parallel importer’s products both are legitimate and so it is not clear how restrictions on arbitrage would be pro-competitive. There is no empirical data to determine that arbitrage can harm authorised distributors through their free riding, as often claimed. If the parallel imports manufactured by the licensee are materially different and inferior from the patented products then the issue of consumer deception can occur.105 In any such case the burden should be on the patent holder to prove the difference in quality standards through systematic quality tests. In other circumstances the issue of free riding can only be justified to some extent when the authorised distributor provides a product take back guarantee or free service warranty in any country where there are authorised distributors. In such a case it is important to notify the buyer that the product has come through the parallel channel wherein the tied-up service-warranty or product guarantee is not available. It is up to the consumer to choose whether to opt for a low-priced product without service-warranty or a high-priced local product that comes with tied service-warranty.

3.2.3 Economic Reasoning for ‘Regional Exhaustion’ of Patent Rights

Conceptually there was no existence of ‘Regional Exhaustion’. Regional exhaustion is a blend of national and international exhaustions, introduced in Europe through case law fundamentally based on free movement of goods within a cu. It is based on the economics of barrier free trade in the European Union market, a cu and was created through judicial pronouncements by the ecj prior to codification in secondary legislation (directives and regulations) in shaping the common market. In spirit, the practice of regional exhaustion in Europe, more specifically within the eea is based on Article 34 of the Treaty on the Functioning of the European Union (EU Treaty) which states,

“[q]uantitative restrictions on exports, and all measures having equivalent effect, shall be prohibited between Member States.” read with the exception for, “… the protection of industrial or commercial property.”

Hence it is well established that the aim had always been to uphold the free movement of goods and services within the European Union where iprs could not become non-tariff barriers.106

Within a multilateral trade regime, regional exhaustion for the cu draws its validity from Article xxiv of General Agreement on Tariffs and Trade (gatt) that provides the internal and external requirements crucial for its formation. Article xxiv 5 (a) restricts the external duties and other regulations imposed on its formation from being higher or more restrictive than that before the cu was formed. Article xxiv 8 (a) (i) & (ii) while elaborating the internal requirements of the cu, requires duties and other regulations are eliminated on substantially all products being traded within the territories. Additionally, the members of the cu need to apply substantially the same duties and other regulations of commerce to trade of other non-parties. However, although regional exhaustion was based on the free movement of goods by removing the possibility of iprs becoming a non-tariff barrier within the cu, it was initially not introduced for such purpose.

The regional exhaustion mode started as a competition law measure against anticompetitive market power gained due to national exhaustion in the Grundig, Consten Case of 1966.107 In this case Grundig, an electronic goods manufacturing company selling under its trademark registered in Germany and other EU states, appointed Consten SaRL for exclusive distribution of its goods in France. unef, a third-party vendor in France bought the products in Germany and imported and sold them in France. Grundig and Consten alleging infringement of their trademark and copyright in name and logo, complained before the ec. The ec declared that under Article 85 of the Treaty of Rome (now Article 101 of the Treaty of the Functioning of the European Union), intra-brand trade would support free movement of goods within the members. This decision of the Commission was challenged by Consten and Grundig before the ecj and was joined by Germany and Italy. The ecj considered carefully all arguments and decided in favour of the ec deciding that the anti-cartel aspect in European competition law would supersede national trademark laws about the common market.108

It is interesting to note that while regional exhaustion became an established practice in Europe, a comparative analysis will show that other regional blocs did not adopt regional exhaustion. nafta members did not specify regional exhaustion neither any mode of exhaustion and each member followed their own.109 Even in case of asean, regional exhaustion was not adopted. Since its establishment in 1967, there was never an attempt to create EU-like regional institutions hence one would not expect regional exhaustion of iprs too. However, in 2007 the asean Charter was adopted to establish an integrated single market, asean Economic Community (aec) and the aec was launched in December 2015.110 It will be noticed that even when there were efforts to eliminate tariff and non-tariff barriers through adoption of a Common Effective Preferential Tariff Scheme for the asean Free Trade Area111 (afta),112 iprs were kept outside the purview of non-tariff barriers through an exception.

From an economic perspective, it has already been stated that it is incorrect to assume that restricting arbitrage is welfare enhancing. In fact, the welfare trade-offs in regulating arbitrage are circumstantial hence proponents of regional exhaustion try to show that countries with lower trade barriers which are in a region would gain from allowing arbitrage. Because when the cost of allowing arbitrage is less, it is beneficial to allow arbitrage while if such cost were high then imposing a restriction would be better. Arguably this mode of exhaustion was adopted since on one hand it encourages unobstructed trade between the member countries of the EU and at the same time does not restrain the patent holder’s right to exploit the patent. It restricts the possibility of patent rights being used as a quantitative restriction but only within the EU. The ecj relied on this economic reasoning as it was determined to remove trade barriers even if it was in the form of iprs.113

It is interesting to note that the exhaustion is restricted within the EU region and not extended beyond EU countries, the member countries hence do not permit international exhaustion. As a result, the patent holder can restrict parallel imports from outside EU even when it is being imported from a country where the patent holder had consented manufacture of the patent product.114 Thus the basic economic reasoning of the ecj acknowledges that arbitrage can enhance welfare but restrains it within the regional bloc. Thus, regional exhaustion is like international exhaustion with the difference that it restricts the exhaustion within the regional bloc rather than internationally.

Here regional exhaustion applies to only cus and not to ftas, the fundamental premise being the difference between the two in treatment of tariffs, an exception being the eea Agreement. A case in point on copyright exhaustion is Polydor Ltd. and RSO Records Inc. v Harlequin Record Shops Ltd. and Simons Records Ltd. (Polydor case). This parallel import case raised question as to whether enforcement of copyrights held in UK by the right holder against its own licensees in Portugal would result in such measure being quantitative restrictions on imports within the meaning of Article 14(2) of the Agreement between eec and Portugal and was arbitrary discrimination between identical products. It is interesting to note how in a conflict between two private parties in a domestic court, international agreements prevailed in a way giving horizontal direct effect to international agreement, thus directly enforceable by individuals in the eec.115

In right another distinct case on exhaustion of trademarks was the issue of contention within eea was the Mag Instrument Inc. v California Trading Company Norway (Maglite Case).116 Before addressing the case, it must be mentioned that the eea Agreement allows their laws to be interpreted homogeneously in-sync within the EU, thus following ecj jurisprudence through the ‘Court of the efta members’ (efta Court) without adhering to the jurisdiction of ecj. In the Mag Instrument Inc. v California Trading Company Norway (Maglite Case), the efta Court under the eea Agreement allowed Norway to follow international exhaustion irrespective of the exhaustion followed within the EU. It opined that the eea is undoubtedly an enhanced free trade agreement but distinct from the EU which is a cu.

Albeit these are old cases, but nothing has changed for courts using international agreements for dispute resolution. Today with large number of new trade agreements proliferating the multilateral trading arena, disputes are bound to rise and intellectual property rights is expected to be a crucial component. In such scenario instead of each of these rtas and ptas adopting different dispute settlement mechanisms, extending the wto dispute settlement regime could be best suited. In such premise, restraining parallel imports would not be in any way different than the Polydor case.117

3.2.4 Ideal Mode of Patent Exhaustion among the Three Modes

The doctrine of exhaustion in any of its modes is aimed at controlling the re-distribution and commercialisation, rather than the re-production of patented goods. Hence it

neither prohibits ip owners from, achieving the benefits that post-sale restraints might bring about, nor does it totally impair their ability to do so.118

The foundational reason to grant iprs is to enable the inventor or creator to get the market returns related to the invention by restraining competitors from using the patented invention without consent and thus provide incentive to innovate further. This would result in net efficiency gain and allow efficient market operation only if such exclusivity does not supersede the benefits of enhanced innovation. International exhaustion establishes this benefit-cost optimisation by allowing the purchaser of the patented goods to develop a secondary market competitively, restraining the patent owner to enforce exclusive rights in this second market.119

Based on comparative advantages to the parallel importer, the mode of exhaustion enables reduction of national welfare loss through arbitrage. By allowing some of the profits from the sale of patented products to be shared by nationals, it becomes welfare enhancing.120 However, sometimes it is argued that if arbitrage is allowed, the patent holder will not be accorded legitimate protection to his products due to the deception caused by the parallel imports. Such an argument fails any justification since the patent holder himself authorises the production of licensed products under the patent. Thus, only because the products are manufactured by the licensee outside the country cannot make them infringed products. It is the patent holder’s conscious decision to license the product and further it follows only after a negotiated royalty is paid, hence the question of deception does not rise.

There is no doubt that the patent holders would be able to maximise profits when they are able to segregate markets and differentiate price as per local demand. This would be possible if there is a single price in each market, but if it is a heterogeneous market with differentiated prices depended on different factors (e.g. quick access to the patented goods), then it would only be possible if the price equations allow higher profits. However, the argument put forward by the proponents of national exhaustion is due to fact that different markets bear different prices, depending on social and economic welfare of a country at large. These results in differences between rich and poor hence need for price differentiation according to different markets, particularly in the pharmaceutical sector, but also in others like in copyright industry, undermining prices in rich markets. Typically, parallel trade, based on international exhaustion of patents would usually occur at the wholesale level and very limited at the retail consumer level. This is mainly because often goods imported at parallel would not be tied with complementary services and sometimes even lack warranties. In such scenarios it would be erroneous to consider that parallel trade would take place only because there is price discrimination.121 Hence even when international exhaustion is followed, there are many other factors that would determine if parallel trade would be possible.

Apart from the arguments that have been discussed, there is a general reasoning that arbitrage permits local consumers to avail patented products at a lower price through enhanced market competition. The parallel imports are based on the principles of free trade that allows efficient allocation of international resources in a way helping developing country licensees. It dismantles trade barriers and thus helps relocation of production bases to developing countries given their low establishment and overhead costs. As a result, it enhances the production ability of number of countries as they receive new technology promoting local entrepreneurship.122 Legitimizing parallel trade by adopting international exhaustion would enable greater competition, as distributors would compete with each other. Given that parallel trade would reduce the profits of the patent holder instead of maximising profits, it is natural for patent holders to set the wholesale prices to limit or eliminate possibilities of parallel trade.123 The result would be influenced by the size of the market, the ability of the licensee to negotiate and finally the legal regime as to whether it would allow or disallow international exhaustion. However, sometimes completely different arguments are raised like parallel trade would discourage investments in new technologies. These arguments are not supported by empirical data and are unjustified reflection of favourable bias towards patent holders.124

The argument in favour of restricting arbitrage based on Ramsey pricing also does not hold, given the fact that such pricing can only be beneficial if it can regulate the returns. In Ramsey Pricing (named after economist Frank Ramsey, 1927), economic welfare maximises when firms achieve their pre-set profit targets wherein as the elasticity of demand increases the optimal tax decreases.125 Thus, if there is a single regulator that can restrict firms to make only normal returns to cover the sunk costs, restricting arbitrage based on Ramsey pricing will be efficient. However, the situation is different, in most cases firms try to earn more than the ‘normal returns’ and due to the independence of different markets, there is no single regulator that can set the prices globally. In such circumstances, banning arbitrage based on Ramsey pricing will not be supportable.

Further, it is argued that market segmentation is best for r&d i.e. arbitrage affects r&d negatively and that parallel trade reduces the profit that exercise of the ip (in this case, patented good). As such, given that profitability depends on the willingness to invest in new technologies, parallel trade enabled through international exhaustion reduces investment in r&d.126 The most relevant industry in this case is perhaps the pharmaceutical industry but even in such a sensitive industry, evidence on parallel imports does not support such claims. In the 1990s, r&d in the pharmaceutical industry in Sweden and Denmark showed considerable increase even when they were high parallel import recipient countries. On the other hand, Canada on restricting parallel importation of pharmaceuticals, experienced increase in r&d activities. This shows that allowing or disallowing arbitrage (enabling or disabling parallel trade) does not necessarily affect r&d or in other words, does not affect introduction of new medicines negatively.

On the contrary, it is international exhaustion that facilitates attraction of more capital since it allows the lender to dispose of licensed ip products after the first sale as the rights are exhausted. Lenders usually prefer to have control of the patented products that are to be manufactured with the help of their money (until such borrowed money is repaid). In case of international exhaustion, the licensor of the patent (i.e. the patent holder) cannot control the movement of the product after the first sale.

Thus, the lender can use the patented products that are manufactured as collateral security,

Lending on goods incorporating associated intellectual property in a given jurisdiction would be promoted if the jurisdiction adopted the exhaustion doctrine, either in its intellectual property law regime or its secured transactions regime, in a formulation that gives secured lenders greater certainty that they may realize on their security rights in the genuine goods, lawfully made copies, and goods made and transferred with the authority of the patent owner, without permission by the licensors of the associated intellectual property.127

64

Ibid at 5, See “The Summary and Conclusions” chapter of Penrose Edith Tilton, “Economics of the International Patent System” reproduced, pg. 121.

65

Arrow Kenneth, “Economic Welfare and the Allocation of Resources for Invention”, in the “Rate and Direction of Inventive Activity: Economic and Social Factors”, Nelson (ed.), pg. 609, 1962. Also see, “The Summary and Conclusions” chapter of Edith Tilton Penrose, “Economics of the International Patent System” reproduced. Pg. 8, 2019.

66

Barzel Yoram, “Economic Analysis of Property Rights”, Cambridge University Press 2nd edition, 1989.

67

Kitch Edmund, “The Nature and Function of the Patent System”, Journal of Law and Economics 20, pgs. 265–290, 1977. Available at, http://www.law.nyu.edu/sites/default/files/upload_documents/Kitch.pdf.

68

Ibid at 47, pg. 36.

69

Ibid at 5, pg. 119.

70

Friedman David, Landes William and Posner Richard, “Some Economics of Trade Secret Law”, Journal of Economic Perspectives, pg. 61–72, 1991.

71

Braga Carlos Primo and Fink Carsten, “The relationship between intellectual property rights and foreign direct investment”, Duke Journal of Comparative and International Law, pg. 168, 169, (163–186) 1998.

72

Landes William and Posner Richard, “The Economic Structure of Intellectual Property Law”, The Belknap Press of Harvard University Press, pg. 300, 2003.

73

Maskus Keith and Reichman Jerome, “The Globalization of Private Knowledge Goods and the Privatization of Global Public Goods”, 7 (2) Journal of International Economic Law, pg. 285, (279–320) 2004.

74

Dijk Theon van, “The Economic Theory of Patents: A Survey”, merit Research Memorandum 2/94–017, Maastricht Economic Research Institute on Innovation and Technology, Netherlands, pg. 7, 1994.

75

Dasgupta Partha, “The Economic theory of Technology Policy: An Introduction” in Dasgupta Partha and Stoneman Paul (eds.), “Economic Policy and Technological Performance”, Cambridge University Press, Pg. 7–20, 1987.

76

Nelson Richard, “Introduction to the Rate and Direction of Inventive Activity: Economic and Social Factors” in Nelson Richard (ed.), “The Rate … Factor”, Princeton University Press, pgs. 1–16, 1962.

77

Langinier Corinne and Moshini Gian Carlo, “The Economics of Patents: An Overview”, card Working Papers, pg. 6, 2002. Available at, https://lib.dr.iastate.edu/cgi/viewcontent.cgi?Article=1317&context=card_workingpapers.

78

Ricardo David, “On The Principles of Political Economy and Taxation”, 1817 (third edition 1821), Batoche Boohenerks Kitc 2001. (Available at https://socialsciences.mcmaster.ca/econ/ugcm/3ll3/ricardo/Principles.pdf).

79

Krugman Paul and Obstfeld Maurice, “International Economics Theory and Policy”, Pearson Education, pg. 12, 2000.

80

Autarky has its roots in the Greek meaning ‘self-sufficiency’. It is usually referred to trade policies that aim in maximising trade within the country and minimising trade with other countries.

81

Pigou Arthur Cecil, “The Economics of Welfare”, Macmillan and Company Ltd., pg. 175, 176, 4th Edition 1932. Available at, http://files.libertyfund.org/files/1410/Pigou_0316.pdf.

82

Ganea Peter, “A comparative study on parallel imports in patented and trademarked commodities in Japan and in the EU, discussed in the light of economic theory”, Institute of Intellectual Property, Japan, pg. 4, 5, March 2001.

83

Katz Ariel, “The economic rationale for exhaustion: distribution and post-sale restraints” in Calboli Irene and Lee Edward (eds.), “Research handbook on Intellectual Property Exhaustion and Parallel Imports”, Edward Elgar Publishing Ltd., pg. 25, (23–43), 2016.

84

Vautier Kerrin, “The Economics of Parallel Imports”, in Heath Christopher and Sanders Anselm Kamperman (eds.), “Industrial Property in the Bio-Medical Age – Challenges for Asia”, Kluwer Law International, pg. 187, 2003.

85

Rey Patrick and Stiglitz Joseph, “The Role of Exclusive Territories in Producers’ Competition”, 26 (3) Rand Journal of Economics, pg. 431–451, 1995.

86

Fink Carsten, “Entering the Jungle of Intellectual Property Rights – Exhaustion and Parallel Imports”, Department of Economics, University of Heidelberg, Germany, pg. 13, 14 (2–23) 1999.

87

Maskus Keith, “Intellectual Property Rights in the Global Economy”, Institute for International Economics, Washington D.C., pg. 214, 2000.

88

Crampes Claude and Hollander Abraham, “The pricing of pharmaceuticals facing parallel imports”, Journal of Economic Law, University of Montreal, pg. 8, 2003.

89

Anderson Simon and Ginsburgh Victor, 7 (1) Review of International Economics, pgs. 126–139, 1999.

90

This provision of restraining exhaustion in case of imported products being materially different was first established in USA in the Lever Brothers case interpreting Section 42 of the Lanham Act which statutorily allows parallel imports of trade marked products. Due to their material differences the products were not considered as genuine. Hence although marketed under identical trademark to that registered in USA were not considered exhausted due to their material and physical difference. Lever Brothers Co v United States of America, eta al., 877 F.2d 101 (d.c. Cir. 1989) and Lever Brothers Co v United States of America, eta al., 981 F. 2nd 1330 (d.c. Cir. 1993).

91

Malueg David and Schwartz Marius, “Parallel Imports, Demand Dispersion, and International Price Discrimination”, 37 Journal of International Economics, pgs. 167–195, 1994.

92

Hammer Peter, “Differential Pricing of Essential aids Drugs: Markets, Politics and Public Health”, 4 (2) Journal of International Economic Law, Oxford University Press, pgs. 886, (883–912), 2002.

93

Ibid at 55, pgs. 18.

94

Watal Jayashree, “Intellectual Property Rights in the wto and Developing Countries”, Oxford University Press, pgs., 301, 2002.

95

First introduced by British economist Frank Ramsey, the concept of ‘Ramsey pricing’ states that the mark-up price should be inverse to the price elasticity of demand. Thus, with an increase in the demand for the product, the price mark-up should be reduced.

96

Danizon Patricia, “Pharmaceutical Price Regulation: National Policies versus Global Interests”, The American Enterprise Institute, Washington D.C., 1997.

97

Ibid at 55, pg. 38, 39.

98

Maskus Keith, “Benefiting from Intellectual Property Protection”, in Bernard Hoekman, Aaditya Mattoo and Philip English edited, “Development, Trade and the wto – A Handbook”, The World Bank, pg. 377, 2002.

99

Maskus Keith, “Parallel imports in pharmaceuticals: Implications for competition and prices in developing countries”, Final Report to World Intellectual Property Organisation, pg. 8, April 2001.

100

Drexel Josef, “EU competition law and parallel trade in pharmaceuticals: lessons to be learned for wto/trips?”, in Jan Rosén edited, “Intellectual Property at the Crossroads of Trade”, Edward Elgar Publishing Ltd., pg., 6, 7, 12, (3–24), 2012.

101

Danton Patricia, “The Economics of Parallel Trade”, in Towse Ruth and Holzhauer Rudi (eds.), “The Economics of Intellectual Property”, Edward Elgar Publishing Ltd., pg. 365, (358–370), 2002.

102

Maskus Keith, “Economic perspectives on exhaustion and parallel imports” in Calboli Irene and Lee Edward (eds.), “Research handbook on Intellectual Property Exhaustion and Parallel Imports”, Edward Elgar Publishing Ltd., pg., 110, 111 (106–124), 2016.

103

who, “More Equitable Pricing for Essential Drugs: What do we mean and what are the issues?”, pg. 3, Background Paper prepared by the who Secretariat for the whowto Secretariat Workshop on Differential Pricing and Financing of Essential Drugs, Hosbjor, Norway from 8th11th April 2001. The paper states that because pharmaceutical purchases in developing and ldc are mainly financed by individuals where they are negotiated individually prices of medicines are often higher than those in developed countries where the prices are often negotiated by insurance companies or the government.

104

Cottier Thomas, “Parallel Trade and Exhaustion of Intellectual Property in wto Law Revisited”, in Ruse Khan Grosse Henning & Metzger Axel (eds.), “Intellectual Property Ordering Beyond Borders”, Cambridge University Press, pg. 193 (189–232), 2022. Also see, Clugston Christopher, “International Exhaustion, Parallel Imports and the Conflict between the Patent and Copyright Laws of the United States”, 3 Beijing Law Review, Vol 4, pgs. 95–99, 2013.

105

Hilke John, “Free Trading or Free-Riding: An Examination of the theories and available empirical evidence on gray market imports”, 32 World Competition, pg. 80, (75–91), 1988.

106

Ghosh Shubha, “Incentives, contracts and intellectual property exhaustion” in Calboli Irene and Lee Edward (eds.), “Research handbook on Intellectual Property Exhaustion and Parallel Imports”, Edward Elgar Publishing Ltd., pgs., 153–154 (125–170), 2016.

107

Consten SaRL and Grundig GmbH v Commission of eec (1966), Case 56/64. Available at, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:61964CJ0056&from=EN.

108

Cottier Thomas, “Parallel Trade and Exhaustion of Intellectual Property in wto Law Revisited”, in Ruse Khan Grosse Henning & Metzger Axel (eds.), “Intellectual Property Ordering Beyond Borders”, Cambridge University Press, pg. 192 (189–232), 2022. Also see, Ebb Lawrence, “The Grundig-Consten Case Revisited: Judicial Harmonisation of National Law and Treaty Law in The Common Market”, 6 University of Pennsylvania Law Review, Volume 115, pg. 856–859 (855–889), 1967.

109

Ibid at 106, pgs., 158 (125–170).

110

The asean Members committed to accelerate the establishment of the asean Economic Community in the Cebu Declaration on the Acceleration of the Establishment of an asean Community by 2015. asean, Cebu Declaration on the Acceleration of the Establishment of an asean Community by 2015 (Jan. 13 2007). The asean Community consists of three pillars of the asean Security Community, asean Economic Community (aec), and asean Socio-Cultural Community and this form the roadmap for an asean Community 2009–2015.

111

Agreement on the Common Effective Preferential Tariff (cept) Scheme for the asean Free Trade Area (afta), Jan. 28, 1992, art. 5, wipo Lex. No. trt/afta/001 [hereinafter cept-afta].

112

But Article 8(d) of the asean Trade in Goods Agreement (atiga) stipulates that the protection and enforcement of trademark rights (iprs) may constitute a general exception to the prohibition to non-tariff barriers within asean. atiga, Feb. 26, 2009, wipo Lex. No. trt/asean/001. atiga replaced the earlier cept-afta scheme signed in 1992.

113

Ibid at 60, pg. 56.

114

Ibid at 60, pg. 57.

115

Polydor Limited and rso Records Incorporated v Harlequin Record Shops Ltd. and Simons Records Limited, Case 270/80 [1982], ecr 329. Available at, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:61980CJ0270.

116

Mag Instrument Inc. v California Trading Company Norway, Case E-2/97 [1997], efta Ct. Rep. 129. Available at, https://eftacourt.int/cases/e-02-97/.

117

Cottier Thomas, “Intellectual Property and Mega-Regionals Trade Agreements: Progress and Opportunities Missed”, in S Griller, W. Obwexer, Erich Vranes (Eds.), “Mega-Regional Trade Agreements: ceta, ttip and TiSA”, Oxford University Press, pgs. 151–174, 2017.

118

Ibid at 83, pg. 34.

119

Chiappetta Vincent, “Working toward international harmony on intellectual property exhaustion (and substantive law)”, in Calboli Irene and Lee Edward (eds.), “Research handbook on Intellectual Property Exhaustion and Parallel Imports”, Edward Elgar Publishing Ltd., pg. 129 (125–144), 2016.

120

Watal Jayashree, “Parallel Imports and ipr-Based Dominant Positions: Where Do India’s Interests Lie?” in Cottier Thomas and Mavroidis Petros (eds.), “Intellectual Property: Trade, Competition and Sustainable Development” The Univ. of Michigan Press, pg. 200, (199–209) 2003.

121

Ibid at 102, pg. 115, 116.

122

Frederick Abbott, “First Report (Final) to the Committee on International Trade Law of the International Law Association on the subject of Parallel Importation”, 1 jiel 4, pg. 607, (607–636), 1998.

123

Ibid at 102, pg. 117.

124

Ibid at 102, pg. 118.

125

See Oxford dictionary of Economics, https://www.oxfordreference.com/view/10.1093/oi/authority.20110803100403450.

126

Ibid at 102, pg. 118.

127

Commercial Finance Association (cfa), “Intellectual Property Issues Affecting a Secured Transactions Regime”, March 2004.

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